There is a robust debate among policymakers on whether to impose restrictions on the incentive pay of bankers. Proponents of such restrictions point to the great financial crisis and argue that enormous compensation packages give top executives and traders at banks incentives to take excessive risks. These concerns led to regulations on bankers’ incentive pay, such as the 2013 Capital Requirements Directive IV (“bonus cap”) regulation in the EU, which required that the maximum variable-to-fixed compensation ratio of material risk takers (MRTs) at EU banks should not exceed 100 percent (or 200 percent, subject to shareholder approval). Yet opponents argue that the restrictions make it harder for banks to attract high-quality executives and traders, thus hurting bank value. However, there is no empirical evidence that pay restrictions are either necessary or sufficient to curtail bank risk, or that repealing the restrictions will improve bank value.

In a new study, we use a recent deregulation of banker compensation in the UK to identify the effect of bankers’ incentive pay on bank risk and shareholder value, and to evaluate the efficacy of banker pay regulations in curtailing bank risk. On October 24, 2023, UK financial regulators announced that UK banks would not be subject to the EU’s bonus cap regulation starting on October 31, 2023. Using unique hand-collected data, we show that EU’s bonus-cap rule was binding for UK banks in 2014 (when UK was part of the EU) for both senior and non-senior MRTs. Therefore, UK’s bonus-cap removal significantly expands the compensation contracting space of UK banks, which are widely expected to significantly increase the use of variable pay. At the same time, EU banks continue to be subject to the bonus cap.

Contrary to the fears of policymakers, there is no significant increase in the credit risk, idiosyncratic volatility, or tail risk of UK banks after the pay deregulation. However, there is a significant increase in the systematic risk (i.e., market beta) and leverage of UK banks, which is consistent with arguments that increase in pay convexity gives risk-averse managers an incentive to increase systematic risk, which they can hedge by trading the market portfolio.

Surprisingly, the pay deregulation does not have a positive effect on the equity values of UK banks, despite the widespread belief that pay deregulation will enhance the competitiveness of UK banks by making it easier for them to attract talent. This suggests a countervailing negative effect of pay deregulation on bank equity value that negates the benefits of greater flexibility in setting compensation. One possibility, highlighted by theories of labor market competition among banks, is that pay deregulation is likely to intensify labor market competition among UK banks, thus imposing a negative externality on their equity values.

We test these predictions by examining the effect of UK’s bonus cap removal on the compensation structure of MRTs in UK banks. We do these tests separately for the following categories of MRTs: top managers, other senior managers, and non-senior managers. Consistent with intensification of labor market competition following UK’s bonus cap removal, we show that the total compensation per person for top managers at UK banks increases by about 17 percent in 2024 (equivalent to a $2.43 million increase) compared with EU banks, largely driven by increase in variable pay even as fixed pay remains unchanged. Overall, the variable-to-fixed ratio of top managers at UK banks increases by 76.2 percent compared with those at EU banks. We find smaller increases in the total compensation per person of other senior managers and non-senior managers, but there is no change in variable-to-fixed ratio at these levels.

Finally, we show that banks have persistent differences in their reliance on compensation packages that are highly sensitive to performance (“bonus culture”). Specifically, we classify UK banks into two groups – high and low – based on their variable-to-fixed ratio in 2013 (i.e., almost a decade prior to UK’s bonus cap removal). We find that the increase in variable-to-fixed ratio of top managers at UK banks after UK’s bonus cap removal is almost three times larger for UK banks in the high  group than it is for those in the low group. This is a striking result because restrictions on variable pay were in place for almost a decade. It points to a persistent bonus culture at banks, which is reminiscent of a persistent risk culture at banks.

Our paper offers several insights and policy implications. First, with stringent banking regulations, increase in pay convexity of bankers may not have a significant effect on banks’ tail risk, but can still give managers an incentive to increase systematic risk, highlighting the importance of considering differential risk-taking incentive effects. Second, restrictions on incentive pay benefit banks by limiting labor market competition among banks. To our knowledge, we are the first to empirically examine these labor-market effects of regulatory interventions in bankers’ pay. Third, compensation culture at banks tends to be highly persistent.

This post comes to us from David De Angelis, Hitesh Doshi, Mark Liang, and Vijay Yerramilli at the University of Houston’s C. T. Bauer College of Business. It is based on their recent paper, “The Effect of Unlimiting Bankers’ Incentive Pay on Bank’s Risk Profile and Value,” available here.